The Dilemma: Debit or Credit Spread?

05/15/2014 8:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

Josip Causic of Online Trading Academy details an in-depth comparison of debit and credit spreads, revealing the differences as well as important considerations for traders looking to execute each of the strategies.

In this article, I will compare a vertical debit spread, also known as the bear put spread, with a vertical credit spread, or bear call spread.

Keep in mind that the buying of a debit spread ideally should be done when the implied volatility (IV) is low, while the selling of a credit spread is done when the volatility is high or in the higher range. For simplicity's sake, I am taking IV out of the discussion for these two examples.

Credit Spread (Bear Call Spread)
For our bear call spread example, we are buying the 67 call first and then selling the lower strike price, or 66 call. The 63 strike is near the money, the 64 is one step out of the money (OTM), and the 65 is two steps OTM.

Our short 66 call is basically three strikes away from the current price of our underlying, which is trading at $62.71. Although the 67 is five single-point strikes away from the money, we do not intend to utilize the long 67 call as the right to purchase the stock, which is currently trading $4.29 lower than this call.

The only reason why the sale of the 67 call is done is to hedge/cover our otherwise naked 66 call. Since we are selling premium, at a net credit, we would want to be less than 60 days from expiry. By the way, for this bear call, we have not sold the front month—May—which virtually had very little premium, but we sold the June instead.

chart
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The figure above assigns prices of premium to the two strike prices in order to point out that the maximum profit on this vertical credit call spread is only $17 per contract, minus commissions. The goal of a bear call is to keep as much of that $17 net credit as possible. Again, I am emphasizing the words, "as much as possible."

Still, also keep in mind how much is at risk in this trade. If our max profit is $17, then our max loss is the difference between the strike prices (67 call – 66 call = $1 x 100 shares) and the credit we have taken in: $100 - $17 = $83.

In terms of the rate of return, the max profit must be divided by the max loss, or 17/83, which would give us 20% in a bit less than a month; don't forget that when commissions are included, the percentage of return decreases. The maximum profit is achieved when the underlying closes anywhere below the sold 66 call at expiry.

NEXT PAGE: Study a Bear Put Spread Example

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Debit Spread (Bear Put Spread)
The main difference between the bear put and the bear call spread is that when placing a bear call, you are thinking about what price the underlying will not exceed, but for the bear put, you are thinking about what price the underlying will not go below.

With the help of technical analysis, once we have forecasted where the underlying will likely not fall below, it will be clear which strike price to sell. On the chart, 61 looked like a strong level of support, and so the 61 strike was sold. However, the action of selling the 61 put should only be done after the action of buying was performed.

Due to the fact that we need to buy a long option and be long net premium, we have gone out 60 days plus, which in our case was July. The bear put is a vertical spread, so both the long and short legs need to be in the same month. The actual trade involved buying the 67 put and selling the lower- strike-price 61 put where strong support is located.

chart
Click to Enlarge

Unlike the previous example, this figure assigns prices of premium to the two strike prices in order to point out the maximum loss.

Why am I switching my focus from the max profit to the max loss? In the case of credit spreads, the difference between the bought and sold premium gives us a credit. A bear put is not a credit spread, but a debit spread, so the difference of the long and short legs gives us the max loss, or the cost of doing the trade.

To figure out the max profit, simply subtract the sold 61 strike from the long 67 and then subtract the debit from that (67 – 61 = 6.00 – 3.59 = 2.41). Keep in mind that both of these vertical strategies are bearish, and to achieve the max profit on the bear put, the price would need to be at or below $61 to get the max profit of $2.41.

To summarize some of the main aspects of these strategies, when debit spreads are traded, it is suggested that we go out 60-plus days and aim at buying one side in the money while selling the other leg out of the money.

Ideally, the sale of the out-of-the-money leg should bring in premium in the amount of one-third the cost of the long leg. (If we bought the long leg for $6, then we would want to sell the short leg for $2.)

With credit spreads, ideally, we would like to sell the shortest possible time, yet if there is no premium in the front-month units, then we need to go out to the next month. Either way, the sale of a vertical credit spread is still done with OTM options for both legs, while again, in the case of a debit spread, the long leg is actually ITM while the short leg is OTM.

In conclusion, in this article, I have compared debit and credit vertical spreads. Please make sure that you understand their differences prior to executing these kinds of trades with your live money.

In order to learn about more of the aspects of trading bear call and bear put spreads, such as breakeven points, etc., you should read another of my articles on The Basics of Vertical Option Spreads.

By Josip Causic, instructor, Online Trading Academy

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